Exchange traded funds often specialize in the type of stocks they own, and one of these specialties is dividend stocks. When an ETF owns stocks that pay dividends, it passes them on to shareholders. If you own such an ETF, you will receive cash as it pays dividends. However, you can forgo the cash payments and elect to use the dividends to buy more shares of the ETF. In this case, the fund doesn't pay you in shares; it still pays out cash. Your broker buys the new shares for you.
Most ETFs pay dividends quarterly. The fund simply holds all of the dividends paid by companies during the quarter and pays them to shareholders on a set date. Some ETFs pay dividends as soon as they are collected from the company. If you own an ETF that holds dividend stocks, you will receive cash dividend payments if you do not tell your broker otherwise.
You can ask to have your dividends automatically reinvested in the ETF you own. Your broker will place an order on the day the dividends arrive, and you will purchase shares of the ETF at the current market price. You cannot buy partial shares, so you may have some cash left over in your brokerage account.
If you elect to have your dividends reinvested, ask if your broker charges a commission on your reinvestment purchases. Many brokers, especially online brokers, offer reinvestment of dividends with no commission. Because you will be buying small quantities of shares each quarter, you could be subject to a minimum commission charge with a broker, and this commission could eat away at your profits. Clarify whether your broker offers commission-free reinvestment of dividends before you choose this option.
As you buy more shares with your dividends, you earn more dividends. This is because you receive a dividend per share, and the more shares you own the more dividends you receive. You can buy a higher number of shares with the higher dividend, and these additional shares result in an even higher dividend. The power of compounding can build your position in an ETF gradually and automatically.
You should check the value of your ETF periodically to see if you have too much of your portfolio in one investment. If you automatically reinvest dividends, your holdings may be larger than you thought. You can rebalance your portfolio by selling some of the ETF shares and buying another type of investment.
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